The Mergers and Acquisitions market in 2009 ranged from the doldrums of the “winter of discontent” to showing real signs of life by the end of the year. M&A activity toward the end of the year (Warren Buffett purchasing Burlington Northern railroad and Exxon Mobil buying XTO Energy, etc.) was certainly indicative that strategic acquisitions are making a comeback. However, it is too early to say that we have hit bottom for several reasons.
I am suspicious that the number of announced deals in 2009 is indicative of a very large pickup in activity. I have seen several prominent M&A group heads quoted on TV and in the Wall Street Journal noting that since 1990, M&A activity has been about a 2-year cycle from peak to trough. By such criteria, 2009 should be the bottom. It is a cyclical business by nature, which goes in tandem with the US economy. Several headwinds exist against the argument that the activity in late 2009 is the advent of a new M&A boom. First, many companies spent 2009 repairing their balance sheets, and many, particularly manufacturing companies, are still in that process. Second, the equity markets were very volatile in 2009. Volatility in the equity markets is usually not conducive to M&A because companies want a fairly stable equity environment before they act, whether their intentions involve making an offer or issuing stock, etc. Finally, even with the comeback of strategic acquisitions over the second half of the year, such deals were often greeted with lukewarm reception from the market.
If this recession proves to be a double-dip recession, we could see another downturn in M&A activity as well. In early 2009, during the depths of the recession, the majority of M&A assignments involved strengthening clients’ balance sheets. We saw this across the entire spectrum from mid-sized companies to components of the Dow and S&P 500 such as Alcoa and US Steel. In Alcoa’s case, Morgan Stanley and Credit Suisse helped raise $1.3 billion via an offering of both stock and convertible debt. This “Rescue M&A” was the focus until about April/May, and acquisitions were about the last thing on the CEOs’ minds.
In December, Paul Parker, global head of M&A at Barclays Capital, said, "If you look deeper into 2009 and you back out rescue financings, which were counted as M&A transactions, we're closer to $1.6 trillion in traditional M&A. So much of this year has been nontraditional M&A and a few mega healthcare deals.” Indeed, the few deals that were executed early in the year involved clearly defined companies, were very conservative in nature, and did not go outside the companies’ core businesses. Perhaps the two best examples of this were Pfizer’s acquisition of Wyeth in January and Merck’s reverse merger with Schering-Plough in March.
In September and October, things began to get interesting. Xerox announced the acquisition of ACS, and Michael Dell announced he was buying Perot Systems. Later, on December 14, Exxon made headway into the Natural Gas business by buying XTO Energy. Suddenly, transformative deals were back in the news - deals where a company was going outside the realm of its core business. The market did not initially digest these deals as well as one would have hoped. The reaction was lukewarm at best (see Charts 1, 2, and 3). It should also be noted that by the end of the year, this trend began to show signs of abating. Warren Buffett’s acquisition of Burlington Northern and Comcast’s purchase of NBC Universal (announced on November 3rd and December 4th, respectively) were well-received and both stocks have reacted favorably since. Nevertheless, the trend over most of the year was not favorable toward strategic acquisitions, as was reflected in the respective stock prices against the backdrop of a great rally in the equity markets.
This presents a problem that many chief executives are now experiencing; they are finding themselves trapped between a rock and a hard place. A CEO will get punished if he or she presides over a low-growth business. However, in an economic environment like that of 2008-09, if he or she tried to do something transformative or strategic, they got punished because the market may have interpreted the acquisition as one that was going outside their realm of expertise. What carries the most significance never changes - it is the return on invested capital, which in the long-term is best for the shareholders.
Too many CEO’s, especially in times like these, are being forced by their boards and, indeed, shareholders to look for growth simply for the sake of growth. This is a phenomenon that is seen close to the peak of any bull market. This is especially relevant as we near the 10th anniversary of the ill-fated AOL-Time Warner merger, announced January 10, 2000. That deal marked the peak of the Technology Bubble (Time Warner’s stock shot up almost 40% the day that the deal was announced), and today serves as perhaps the most egregious example of what can happen when CEO’s focus on growth for the sake of growth. Again, what CEO’s have to look at is not market values, but at the big picture with respect to their company’s position. What are you really paying for the underlying assets? What multiple of cash flow are you paying for the company? What is your return on equity going to be?
In 2009, there is one deal that stands out in my mind that best followed these guidelines. On August 4, PepsiCo announced its intention to re-takeover its distributors Pepsi Bottling Group and PepsiAmericas (it had previously spun them off in 1999). PepsiCo CEO Indira Nooyi and her board wanted to retake control of a core part of their business that they already knew well, and the market rewarded the move (see Chart 4). CEO’s should never forget that bold moves where a company stays within their realm of expertise will be rewarded in almost any environment.
Besides seeing decreased activity in the “corporates” sector, the other major reason 2009 was such a lean year for M&A activity was that its other engine, private equity, has largely been on the sidelines since 2007. Ever since banks became reluctant to lend money for classic leveraged buyouts, their lifeblood of credit has become scarce. Of course, PE bigwigs such as Henry Kravis, Stephen Feinberg, and Ted Forstmann are known for being very smart but, most of all, very adaptive. They thrive on doing deals, and they will find a way to make money in most environments. Therefore, while they are likely to be absent from the $5 billion-plus acquisitions, they are initiating highly structured deals to put their investors’ money to work. Many assets were on the market in 2009, and they often pounced if they found a deal to be attractive.
A great example was the Sept. 17 Kohlberg Kravis Roberts deal for Kodak. KKR came in, assisted with Kodak’s liquidity issues, and will buy $400 million in senior secured notes due in 2017, at an interest rate of 10% to 10.5%. As part of the deal, KKR could control about 20% of Kodak's shares via warrants. Henry Kravis also received two board seats. At the end of the day, it was a vote of confidence in Kodak’s film-to-digital transformation and long-term health. Of course, that does not change the fact that the M&A market is looking forward to banks becoming more willing to lend money for deals with higher leverage, so that private equity firms and corporations can begin to compete on deals once again.
To close, the M&A market appears to be showing some signs of an uptick, but in the grand scheme of the economy it appears to not have gotten ahead of itself. Jeffrey Kaplan, global head of M&A and financial sponsors at BofA-Merrill Lynch, told ThomsonReuters in December, "You need a sustainable economic recovery. You cannot expect the M&A market to flourish without favorable economic conditions. The best deals often are done at the beginning of a recovery. Post-bubbles create opportunities to get great values but are not always the best times for sustained M&A activity." Indeed, the numbers tell the story. M&A totaled about $2 trillion in 2009, down 32 percent from 2008 and down 53 percent from the record high in 2007, according to data from the Wall Street Journal. It all adds to the reasons to hope for a continued economic recovery in 2010.
Chart 1 – Xerox (NYSE:XRX) August 2009-Present
Xerox announced its acquisition of ACS on Monday, September 28, 2009. As you can see, the market did not react favorably. Subsequently, the stock fell off the late 2009 rally until mid-December.
Chart 2 – Dell (DELL) August 2009-Present
This deal was announced on September 22, 2009. The market’s reaction was not favorable, and the stock is still 15% below its 2009 high, despite a December rally.
Chart 3 – Exxon (NYSE:XOM) August 2009 – Present
Exxon announced its acquisition of XTO Energy on December 14, 2009, perhaps the most strategic deal of the year. The market has not reacted favorably in the three weeks since.
Chart 4 – PepsiCo (NYSE:PEP) August 2009 – Present
PepsiCo announced its acquisition of Pepsi Bottling and PepsiAmericas on August 4, 2009. This was perhaps the best-received acquisition of the year, and the company’s stock has been rewarded with a nearly 10% increase since.
Disclosure: No position in stocks mentioned